Earnings Power Value also known as just Earnings Power is a valuation technique popularised by Bruce Greenwald, an authority on value investing at Columbia University. It is arguably a better way to analyze stocks than Discounted Cash Flow analysis that relies on highly speculative growth assumptions many years into the future.
EPV uses a very basic equation which assumes no growth, although it does rely on an assumption about the cost of capital as well as the fact that current earnings are sustainable. It also involves several adjustments to clean up the underlying Earnings figures.
How does EPV work?
The EPV equation is Adjusted Earnings divided by the company's Cost of Capital. This is calculated as follows:
1) Cyclically Adjusted Operating Earnings: The starting point is Operating Earnings, i.e. EBIT. However, this may need to be normalised to eliminate the effects on profitability of valuing the firm at different points in the business cycle. This is done by taking a long term (say, 5-7 years) average of operating earnings, ideally this would be as long as 10 years and including at least one economic downturn.
2) Normalising for non-recurring charges: The next step is to deduct the long term average of non-recurring charges (or normalize them to reflect their true economic nature) to determine the adjusted and cyclically normalised Operating Earnings.
3) Normalised Taxation Adjustment: To this figure, we apply a normalised tax rate – this could either be the average tax rate of the company over, say, the last 5-7 years or alternatively use the general corporate tax rate to avoid the distortive effect of different tax schemes (in the UK, this has been 28%, although it moved to 26% in April this year).
4) Economic Depreciation Adjustment: This involves adding back the depreciation figure of the most recent year, after-tax, which may not reflects the true economic cost of depreciation (it can be higher because capital goods prices go down due to technology advancement, or it may be lower in inflationary environment where reproduction costs is higher then accounting depreciation). Economic depreciation is the cost to the company to make it at the end of the year in the same situation at the beginning of the year, i.e. maintenance capital expenditure. This can be calculated by deducting growth capex from the capex figure in the cash flow statement. Growth capex can in turn be calculated by averaging the Gross Property Plant and Equipment (PPE)/ sales ratio over the long-term (5-7 years) and multiplying this by the current year's increase in sales.
5) Adjusted After-Tax EBIT: This then give the firm’s distributable cashflow. This can then be divided by the company cost of capital to derive Earnings Power Value for the Firm.
6) Cash/Debt Adjustment: To compare this to the Market Cap, it is then necessary to subtract out any corporate debt and add in cash in excess of operating requirements and divide this by the number of shares to get the EPV implied Share Price Value.
If the market price is below the EPV/per share, then the stock may be undervalued – at least according to this view of value!
Once the EPV is determined, it can be compared with the Reproduction Cost (the calculation of which will be discussed in another article). Greenblatt argues that, if EPV is higher than Reproduction Costs, management is creating value and the company is operating at a competitive advantage. If the reverse is true, then management is destroying shareholder value by earning less than the value of the assets and the company operates at a competitive disadvantage (likely to be a commodity business)
Watch Out For
The great advantage of this technique as it does not muddy the valuation process with future predictions. It evaluates a company based on its current situation. That is also however also potentially a weakness in that it may systematically undervalue growth companies. Value investors might regard this as being part of the margin of safety but in normal markets, it may even be difficult to find a company that's selling for less than its EPV.
Another potential weakness is its reliance on earnings, given the scope for companies to manipulate/massage this figure. As Old School Value notes, “Enron had great earnings all the way up to its collapse but free cash flow foretold the troubles long before the scandal surfaced”.
If current earnings aren't sustainable, you'll get an EPV that is too high.
How can I apply this?
From the Source
It’s well worth reading Bruce Greenwald’s tome, "Value Investing: from Graham to Buffett and Beyond and Competition Demystified: A Radically Simplified Approach to Business Strategy" (summarised here) This discusses the EPV technique in detail – see chapters 5-7 where he outlines the apporach and gives a couple of case studies (WD-40 and Intel). You can also see a very interesting set of his lecture slides here.